Wednesday, March 10, 2010

Revenue Recognition (contd.)

Dear Friends,

In my last post I addressed the conceptual framework on revenue recognition. Only when the revenue is both earned and recognizable (i.e. when the earning process is finished or nearly finished and delivery/exchange has taken place), it gets recognized in the financial statements.

I also referred to several exceptions to the afore-said rule, which have been laid out in various  pronouncements under GAAP. These alternative revenue recognition methods are being discussed underneath concisely.

1. Installment and Cost Recovery Methods – Only in restricted conditions, revenues and gains may be recognized using either of these methods.

• Collection of sales price is not reasonably assured;
• Receivables are collected over an extended period of time;
• No reasonable basis for estimating the degree of collectability.

Computation under Installment Method
Revenue is recognized as cash is collected and not at the point of sale.

• Gross profit is recognized in proportion to collection to receivables based on gross profit percentage and the remainder is deferred until collected (realized Gross profit = GP% * Collections for the accounting period).

• Installment receivables and deferred gross profit account are kept separately because gross profit rate may vary from year to year (selling and administrative expenses are excluded in computing the gross profit rate).

•If installments are receivable beyond one year, it should be recorded at the present value of the payments discounts at the market rate of interest.

Computation under Cost Recovery Method

It is similar to installment sales method except that no profit is recognized until cumulative collection of receivables exceed the cost of sales. In other words, profit is only recognized when all cost is recouped through collection of amount.

Note: This method is used when the uncertainty of collection is very high that even the use of installment sales method is precluded.

2. Revenue Recognition when right of return exists – When the buyer has the right to return the product, revenue should be recognized at the point of sale only if all of the following conditions are met:

• The seller’s price to the buyer is mainly set or established at the date of sale.

• The buyer has paid the seller or the buyer is required to pay the seller and the commitment to pay is not reliant on resale of product.

• As a consequence of pilfering, spoilage or mutilation of product, the buyer’s commitment to seller would be unaffected.

• The amount of future profits can be reasonably estimated.

• The seller does not have any impending requirement for future performance to result in resale of the product by the buyer.

If these conditions are not met , revenue must be recognized when the return privilige has substantially expired or the requirements are met. Also any costs/losses related to the sales must be accrued.

3. Long-term construction contracts – These are accounted for by two methods:

• Completed Contract Method and
• Percentage of Completion Method.

When estimates of costs to complete and extent of progress toward completion of long-term contracts are reasonably dependable, the percentage-of-completion method is preferable. When no dependable estimates can be made the completed-contract method is preferable.

Reporting Profit under percentage of completion

Income is recognized as the work on contract progresses.

• Recognized proportionately during contract as a percentage of completion.
(Actual cost to date/Estimated Total cost) * Total estimated contract income
Income previously recognized
Income to be recognized

• The amount of income recognized in the period is added to construction in progress.

Balance Sheet Amount

• Current Asset – excess of costs incurred and income recognized over billings.
• Current Liability – excess of billings over costs and income recognized.

Advantage of using percentage of completion method is that it renders periodic recognition of income and enhances inter-period comparability.

Under Completed Contract method, contract revenue and profit are recognized at completion of contract. All related costs are deferred until completion and then matched to revenues. Though, this method is based on results, it does not reflect the current performance and inter-period comparability is weighed down.

Under both the methods, losses are recognized in the earliest period estimable. Any profits recognized to date are reversed.

Let’s peep and put side by side both the methods through an example. Please follow the link below to view.

I shall resume with this topic in my next post and discuss recognition of revenue related to software, franchise fee and royalty income.

Farewell n be healthy and wealthy!!